Asset Allocation in a Downside Risk Framework

Executive Summary. The traditional Markowitz portfolio optimization has two serious drawbacks. First, mean-variance portfolio optimization is inadequate when asset returns are skewed. Second, investor risk aversion is ignored. A more efficient measure of risk that focuses only on the deviation below a pre-specified target rate of return is defined in a generalized lower partial moment (LPM) framework. The concepts of LPM and co-LPM, a downside measure of the covariance of return, are extended to Markowitz's model to provide a more efficient and robust optimization process. This article demonstrates that downside risk models can be easily implemented using spreadsheet programs and illustrates how investor risk aversion can be incorporated into a downside risk asset optimization model.